A bank, a school district and a 38-year loan

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The fliers touted new ballfields, science labs and modern classrooms. They didn't mention the crushing debt or the investment bank that stood to make millions.

In early 2008, residents of Placentia and Yorba Linda approved a $200 million school construction bond after reading those fliers and being assured repeatedly that “their money will be spent wisely.”

What happened instead was that Measure A led to a debt so large and long lasting that it mortgaged the future of their children's children.

With no public discussion, the school board had hired George K. Baum & Co. and its staff of political strategists to help push the measure through so the district could continue an ambitious building spree.

After the election, the board allowed the bank to sell some of the costliest bonds ever issued by a California public agency. Just one $22 million borrowing from 2011 will cost taxpayers nearly 13 times that amount – $280 million – to repay.

Those bonds, known to Wall Street traders as capital appreciation bonds, are like a loan for which no principal or interest payments are made for 35 years. Interest is charged on a growing pile of unpaid interest, causing the balance to balloon.

“It's another method of pushing debt to future generations,” said state Treasurer Bill Lockyer, who compares the bonds to “payday loans.”

Alexandria Coronado, a former member of the Orange County Board of Education, said: “I just don't understand how these board members got away with this. These people need to be recalled.”

Placentia-Yorba Linda Unified is hardly alone. Bankers from Stone & Youngberg, Piper Jaffray and other firms have traveled all over California in recent years, pushing capital appreciation bonds as a tool to vault over legal debt limits. Hundreds of school districts, including 14 in Orange County, signed up.

But Baum's deals stand out. According to an analysis of data from the state treasurer's office, Baum has issued more than 60 capital appreciation bonds for California school districts since 2007, including the single most expensive such loan. That debt – $283,612 borrowed by San Bernardino County's Rim of the World – will cost future taxpayers 23 times the principal.

Compare that with a 30-year home mortgage with a 5 percent interest rate, which requires payments of about twice the amount borrowed.

“Who borrows money thinking you don't have to even begin to pay interest for 20 years?” asked Kevin Graves of Lake Arrowhead, whose two children graduated from Rim of the World. “The board members knew what they were doing. They did it because there were no consequences.”

The story of how Baum pushed California schools into complex bond deals that charged
payments to future taxpayers is one of naïve public officials, sophisticated financiers, and laws, rules and guidelines ignored:

It is illegal for California school officials to hire political consultants with public funds to help pass bond measures. Using the bank's political consultants is not a legal way around that law, according to the state Office of Legislative Counsel.

Finance experts advise school districts to sell bonds through public auctions to get the lowest interest rate and to employ independent financial advisers to review the details. Placentia-Yorba Linda, like most of Baum's California school clients, did neither.

State law requires that donated consulting work on an election be reported as an in-kind, or non-cash, political contribution. Baum did not disclose its consulting role on state campaign filings in three elections the Orange County Register reviewed.

Placentia-Yorba Linda Superintendent Doug Domene and all five board members declined requests for an interview. Carol Downey, the board's president, sent a written response prepared by Domene. That statement said the district issued the capital appreciation bonds because it wanted to continue building but did not want to raise taxes. The district's construction effort, which began in 2002, has included four new schools, a football stadium and a 600-seat performing arts center.

Domene added that the district also wanted to take advantage of matching construction funds provided by the state, as well as special financing that is heavily subsidized by federal taxpayers.

“It is our belief that our community benefits from these improvements now and into the future,” he wrote.

Robert Dalton, vice chairman of George K. Baum & Co., said in a written statement that the bank has followed “the letter and spirit of the many federal and state laws and regulations that govern our business.”

“As underwriters, we have a clear obligation to deal fairly at all times with issuers and we have a duty to purchase bonds from the issuer at a fair and reasonable price,” he wrote. “In the extremely competitive market of California school finance, underwriters who do not treat their clients fairly and honestly, quickly lose clients.”

BAUM'S OFFER

Placentia-Yorba Linda was four years into a district-wide building plan in 2006 when officials realized they did not have enough money for the classrooms, athletic fields and administrative offices they hoped to build.

They turned to bankers at Baum, a Kansas City, Mo., firm named for the man who founded it in 1928. The executives had already helped the district pass a $102 million bond measure in 2002. This time, school officials wanted to ask voters for even more.

The board rehired Baum, approving the firm's two-page agreement with no discussion.

One word in particular in that agreement put taxpayers at risk.

That word – negotiated – was part of all agreements between the bank and five California school districts that the Register reviewed. With that word, the bank ensured it would be allowed to set the terms of all bonds authorized by voters with the desires of its investor clients in mind.

As an underwriter, the bank buys bonds from the school and then has its traders sell them on Wall Street to mutual funds, hedge funds, insurance companies and individuals. Wealthy Americans have long invested in tax-free bonds as a tax shelter.

Municipal finance experts say school officials often don't realize that the underwriter has investor clients aiming to profit from school bonds.

“A school wants to pay the lowest possible interest rate,” said Joy Howard, a government financial adviser in St. Louis. “But if you're an investor, you want the highest rate, and that is a conflict of interest.”

In a handbook for school finance officers, the California Association of County Treasurers and Tax Collectors advises school officials to avoid negotiated bond deals. Most studies have found that they cost schools higher interest and underwriting fees. The handbook advises schools to sell bonds in an auction where banks compete by written bids. Schools then can select the bank offering the lowest interest rate the market has to offer.

Michael Bishop, deputy superintendent at Santa Ana Unified, said the district's financial adviser urged it to avoid negotiated bond sales. But the district had already signed a comprehensive agreement with Baum that included campaign management services and a specification that all bond sales be negotiated. The district could not get out of that requirement, Bishop said, until all bonds authorized by Santa Ana voters in 2008 were sold.

The treasurers handbook counsels school districts that go ahead with a negotiated sale to hire a financial adviser who is independent from the bank and doesn't have investors to please.

Placentia-Yorba Linda did not do that either.

CREATING A CONSTRUCTION PLAN

A bank that underwrites school debt is paid as bonds are sold. Baum's business model includes a service that keeps schools' construction contractors busy and underwriting fees flowing. The bank helps schools create a construction proposal called a “capital facilities plan.” School officials determine what they would like to build in the coming years, and the bank designs a package of debt to fund it.

“When your students count on you,” the bank's brochure states, “you can count on George K. Baum & Company.”

By early 2011, Placentia-Yorba Linda had spent all but $40 million of the $200 million in bonds that voters had authorized in 2008. But Baum executives had overestimated a key factor – real estate appreciation – that goes into the calculation of tax rates that homeowners pay to support the bonds.

The bank had estimated in 2008, just as home prices were plummeting in Orange County, that property in the district would increase in value by more than 4 percent a year for 25 years. Instead, total assessed values fell by 2 percent between 2008 and 2009, were flat the next year, and rose by about 3 percent in 2011 and 2012.

By 2011, taxes per $100,000 of property value were already above what officials had promised would be the highest rate taxpayers would ever pay for the Measure A bonds. Issuing the rest of the bonds to finish construction would push the tax rate further over that line.

The bankers offered a solution. They designed capital appreciation bonds so the district could receive funds but pay nothing until 2031. Most of the money – both principal and interest – is not due until the six-year period ending in 2049 – 38 years after the bonds were sold.

Capital appreciation bonds have been used in government financing for decades. Experts say they can be useful in cases where a government expects sharply higher revenues in the future, but needs money upfront to build a project. For example, a school district in a fast-growing community where large tracts of homes are planned might use such debt to build a school.

But recently, investment banks have promoted these delayed-payment bonds to California schools that do not expect such a homebuilding boom. Executives have told school officials that they need not worry about the higher debt payments in the future. They predict that real estate values will appreciate faster in the future, keeping tax rates from escalating.

“Long-term CABs help a school district better manage its annual tax by shifting debt payments to future years when assessed values are likely to be higher,” advises Stone & Youngberg, a San Francisco investment bank, in an online guide for California schools.

At the same time, Wall Street analysts have been promoting these bonds to investors.

In June 2011, Vikram Rai, an analyst at Citigroup, advised the bank's clients to invest in capital appreciation bonds issued by California schools because of their high interest rate. Rai said last fall that the bonds were so attractive that even foreign investors were buying them.

The result of Wall Street's promotion: an increasing demand and supply of the bonds that have benefited banks and investors while costing future Californians billions.

On the afternoon of Feb. 8, 2011, the Placentia-Yorba Linda board unanimously authorized the superintendent to issue bonds that shifted the schools' funding problem three decades into the future.

A copy of the resolution shows that the amount of capital appreciation bonds to be sold was blank.

ABOVE-MARKET RATES

Inside the bond market, a private place where traders still make bids over the phone, it was quickly apparent that the Placentia-Yorba Linda bonds favored Wall Street investors.

First, the bonds were not callable. That means the district can't ever buy them back to get a better deal.

Second, the bank priced them with interest rates as high as 7.8 percent.

Market indexes of interest rates on March 30, 2011, the day the bonds were sold, show that governments were paying less than 5.5 percent for 40-year bonds that required regular payments of interest. Investors demand a higher rate for capital appreciation bonds, however, because they must wait decades for their money. But experts said the rates that Baum negotiated on most of the bonds – 7.5 percent to 7.8 percent – still appear high. A rate even a quarter of a percent lower would have saved the district millions.

Trading records from the Municipal Securities Rulemaking Board show that some investors who bought the bonds quickly resold them at a profit. One speculator bought $347,500 in bonds from the bank and resold them five days later at a 4 percent profit, more than $14,000.

Tim Schaefer, founder of Magis Advisors, a Newport Beach firm that advises governments on financial deals, said these flips by speculators are “a very strong indicator that the bonds have been mispriced.”

One mutual fund company, Franklin Templeton Investments, bought two-thirds of the bonds a few months after they were issued. The fund paid less than $30 million for bonds that will pay out $200 million from 2043 to 2049.

Dalton, Baum's vice chairman, said that the interest rate on Placentia's bonds was similar to what other California schools paid for capital appreciation bonds at that time. He said school officials had decided to make the bonds non-callable to avoid an even higher rate.

“We are very proud of our ability to achieve market interest rate levels for our clients,” he said.

Superintendent Domene said the public should view the cost of all $200 million in bonds issued under Measure A, and not just the capital appreciation bonds, which require future taxpayers to pay nearly $13 for each $1 borrowed. When the other bonds are included, he said, taxpayers will pay $3.45 for each $1 received.

For its work, Baum received a fee of 1.1 percent of the bonds' principal amount, about $2 million for Measure A's $200 million in bonds.

The national average for an underwriting fee on education bonds in 2011, according to a survey by the Bond Buyer, was about half that amount or 0.613 percent. An analysis by state officials found that underwriters in California were paid an average fee of 0.95 percent from 2009 to 2011 on bond issues of the same size that Placentia sold.

“Our fees are in line with California rates,” Dalton said in his statement.

POLITICAL CONSULTING

California law is clear: It is illegal for school officials to use public money to hire political consultants to pass bond measures.

You wouldn't know that if you followed Baum executives around the state.

In dozens of presentations, the executives have explained how schools get far more than a bank with decades of experience in bond underwriting. The schools also get step-by-step instructions on putting a bond measure on the ballot, the bankers explain, as well as aid from its political strategists.

If the measure fails, the bank assures schools, they owe nothing.

For dozens of districts, this was too good to pass up.

The bank has “a full-service, in-house election team comprised of a campaign specialist, a pollster, copywriters, graphic designers and database professionals,” according to its website.

Its executive team in Sacramento includes Ann Marie Nock, manager of its Bond Election Group. Executives told Fountain Valley school officials in a proposal last year that Nock was “a veteran of over 200 successful elections.” Another executive, according to the proposal, is Alan Gafford, a vice president “responsible for developing strategy and executing tactics for school bond elections.”

Nock told the Fountain Valley board that its political campaign would be “aggressive” and include phoning voters and walking precincts. In a presentation at Burbank Unified in 2009, Nock said the bank won elections by “marketing the right message” and “creating a sense of urgency” that schools needed money, according to the meeting's minutes.

Downey, the board's president, insisted that Baum's work for Placentia-Yorba Linda did not include political consulting. She said no school funds were paid to Baum for political work.

But documents and interviews show that the bank was deeply involved in the election.

According to a 52-page campaign report the bank's political strategists prepared for Placentia-Yorba Linda officials in 2006, their pollsters surveyed 400 residents by phone to determine their likelihood of voting for the bonds and what political messages worked to persuade them.

The pollsters determined that residents responded more favorably to the message that the bonds were needed to “prepare students for vocational employment as well as college” than to one saying the district needed a “second bond” to “continue upgrading” facilities.

The bank's strategists urged the district to get those residents whom its strategists found to be most likely to support the bonds – renters, Democrats, women and parents of young children – to the polls.

Former Baum vice president Gafford confirmed in an interview that he had worked on Placentia's political campaign, including organizing volunteers, recommending designs and messages for signs and literature, and writing the script for phone bank volunteers.

In addition to the political consulting, the bank gave $25,000 to the campaign. Its donation was quickly followed by other large contributions from law firms, architects, construction contractors and other companies hoping to profit from the bonds and building projects. In all, companies from outside the community gave more than 90 percent of the $150,000 collected by the political committee.

A company paying employees to work on a campaign in California must report the value of those services as a contribution, according to the state Political Reform Act. Breaking the law can result in fines of up to $5,000 per violation.

But Baum did not report any in-kind donations for political consulting for the time spent by Nock, Gafford or its pollsters in the elections in Placentia, Santa Ana and Fountain Valley – all campaigns where executives provided many hours of services.

Dalton said the bank began reporting in-kind donations to the federal securities board after it adopted a new requirement in 2010. Asked why no state disclosures were filed, he said, “We have relied on a law firm with expertise in local and federal election law to file our disclosure forms.”

Gafford said executives did not try to hide their involvement. “If they wanted technical and professional help, I was there to do that,” he said. “There was no secret.”

Local volunteers had the final say in the activities, he added: “Parents are the momentum behind these efforts.”

Under state law, it is not illegal for a bank to work as a political consultant in a bond election. But school boards are prohibited from hiring political consultants to push bond measures.

In 2003 and again in 2010, the state's Office of Legislative Counsel was asked whether it was legal for a school district to hire an underwriter based on an oral or written understanding that it would also provide political consulting.

In both cases, the lawyers gave the same answer: Such a deal violates the law.

NATIONAL UPROAR

There has been a growing furor over capital appreciation bonds issued by California schools since a Michigan blogger, Joel Thurtell, revealed last year that a district in San Diego County had issued $105 million in bonds that would cost taxpayers nearly $1 billion to repay. In relative terms, Placentia's bonds are even more expensive than those sold by Poway Unified, which require repayments of $9 for each $1 borrowed.

Last month, state treasurer Lockyer and Tom Torlakson, state superintendant of public instruction, urged schools to stop issuing such bonds until the Legislature considers a bill to limit their use.

“The people running school districts are educators and not generally finance experts,” Lockyer said. “I don't think they knew what they were getting themselves into.”

Larger class sizes

Since Measure A passed in 2008, Placentia-Yorba Linda officials have struggled to find enough money to operate classrooms.

Later that year, the district eliminated some elementary music programs. It has repeatedly forced teachers to take days off without pay. And it has increased class sizes. Before the election, there were enough teachers to have 20 students in each first- and second-grade class, according to budget documents. Now those teachers have 30 students.

The district made those cuts to cope with reduced state funding even as construction firms continued with what officials call a “massive modernization program.”

The district has built four new schools since 2008. Still under construction is a $12 million concert hall that will feature a glass lobby and stage large enough for a 230-member choir.

Daily costs are eating up the district's general fund balance, its reserve for operations. In December, the district told the state it may not meet its bills in the next two years.

No bond money can pay for teacher salaries and other operating costs.

In June, Moody's, the rating agency, placed “a negative outlook” on the district's credit worthiness because its debt burden was higher than similar districts. The agency did not reduce the district's bond credit rating – Aa2 – which is just two notches below the top rating. Moody's analysts warned they may lower the rating if the district continues to borrow and spend its cash reserves.

The district is negotiating contracts with two labor unions, Domene said, and hopes to reverse its expected budget shortfalls. “Residents should not be concerned with the financial condition of the district,” he wrote in a statement.

A bigger problem may come in the future, long after current school officials have retired or stepped down from the board. If property values do not appreciate fast enough to keep up with escalating bond payments, tax rates will have to go up to pay for 35-year-old classrooms. Future administrations may find it hard to borrow money for new construction.

“How are they going to build schools for children in the future?” asked Schaefer, the financial adviser.

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